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Bisogno M. (2012), Audit quality of Italian non listed firms, IJBRD, Vol. 1, no. 1
1. International Journal of Business Research and Development
ISSN 1929‐0977 | Vol. 1 No. 1, pp. 32‐47 (2012)
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* Corresponding author: mbisogno@unisa.it
Audit Quality of Italian Industrial Non-Listed Firms:
an Empirical Analysis
Marco Bisogno
University of Salerno, Italy
Abstract
The study measures audit quality of Italian non-listed SMEs, moving from two elements: i) the Italian law
distinguishes between administrative and financial audit; ii) while listed companies have to assign
administrative audit to the Board of Statutory Auditors (BSA), and financial audit to external auditors.
However, non-listed firms, which are not “entities of public interest” and are not obliged to prepare
consolidated financial statements, can assign both to the BSA. The research compares audit quality
performed by these bodies.
Considering the independence of BSA’s members, it is expected that there are no significant differences
between the two alternatives. Moreover, it is hypothesized that Italian SMEs tend to underestimate
earnings.
The approach adopted differs from previous studies because it analyses SMEs (which represent the wider
market for audit services), while literature mainly analyses large listed firms. Moreover, the modified
Jones’ regression model is adopted to the characteristics of the Italian firms.
Keywords: Audit Quality, Earning Management, Non-Listed Firms, External Auditors and Board of
Statutory Auditors.
1. Introduction
The importance of audit quality has been
emphasised by recent international and Italian
financial scandals; moreover, the present global
crisis has highlighted the “manipulation” of
earnings (the so called earnings management), with
the aim of not showing losses or incomes that do
not reflect the results of previous years. As a
consequence, a renewed interest in the topic can be
observed, as underlined by numerous papers
concerning the role of auditors in providing
constraints on earnings management.
The great part of these studies concerns listed
companies while only few papers (e.g. Mariani et
al, 2010; Van Tendeloo and Vanstraelen, 2008)
pertain to non-listed firms. However, the European
context is characterized by the prevalence of non-
listed (small-medium sized) firms (European
Commission, 2003), whose financial statements
are not widely distributed to the public. As a
consequence, non-listed firms represent the wider
market for audit services and this justifies the
relevance of a study concerning earnings
managements and audit quality of these firms.
The Italian legislation concerning auditing
prescribes a separation between financial audit,
which has to be assigned to external auditors, and
administrative audit, which is in charge of an
internal body, named ‘Board of Statutory Auditors’
(BSA). However, in predefined situations (see
below), non-listed firms (which represent more
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than 95% of the Italian firms) could assign also
financial audit to the BSA.
The aim of the paper is to understand if the choice
of the Italian law to assign financial audit to the
BSA influences the reliability of financial
statements and, as a consequence, audit quality of
Italian non-listed companies. In addition, this
research tries to understand if this choice is
consistent with the characteristics of Italian non-
listed firms, whose main stakeholders are tax
agencies and banks. More specifically, it is
hypothesized that Italian non-listed firms tend to
underestimate earnings because of a high
alignment between financial statements and tax
accounting.
The main result is that there are not significant
differences between auditing activities performed
by BSA and those carried out by external auditors.
International literature assesses the quality of audit
in an indirect way, by examining earnings quality
(Becker et al, 1998); in fact, the reliability of
financial statements can be directly related to the
efficiency of auditing activities because financial
auditors have to express an opinion on the quality
of annual reports, identifying and modifying
unsound financial assessments. On the topic, the
study of Hirst (1994) is emblematic: auditors take
into account the incentives to earnings
management in planning their activity and in
expressing their opinion. Furthermore, many
researches (see, among the others: Becker et al,
1998; Francis et al, 1999; Palmrose, 1988) assess
that the auditor body influences earnings
management, more specifically that Big 4 auditors
are of higher quality compared to non-Big 4
auditors.
The paper adopts the modified Jones’ regression
model, which allows estimating the effects of
different auditing bodies (external vs. statutory
auditors) on discretionary accruals, even if some
further modifications are introduced in order to
take into account the characteristics of the Italian
financial statements.
The paper is articulated as follows: The next
section summarizes the Italian context; section 3
reviews the literature introducing research
hypotheses; section 4 clarifies the research design
and methodology; section 5 illustrates results while
section 6 draws some conclusions, also discussing
the limitations of the analysis.
2. The Italian context
The Legislative Decree No. 6/2003 reformed the
Italian civil code, prescribing three alternative
governance models: ‘traditional’, ‘dualistic’ and
‘monistic’ models. Table 1 summarises their
characteristics.
Table 1
Auditing bodies in the Italian governance models
Model Type of company Administrative Audit Financial Audit
Traditional
Listed
Board of Statutory
Auditors (BSA)
Auditing company
Non listed Type 1 Single Auditor or Auditing company
Non-listed type 2
Single Auditor/Auditing company or
BSA *
Dualistic
Listed Surveillance
Committee
Auditing company
Non listed Single Auditor or Auditing company
Monistic
Listed Committee for
Management Control
Auditing company
Non listed Single Auditor or Auditing company
* If foreseen by company’s by-laws
Type 1: entities of public interest; obliged to prepare consolidated financial statements
Type 2: entities of no public interest; not obliged to prepare consolidated financial statements
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fairness of annual reports of a company. They play
a crucial role not only in discovering GAAP
violations (the so-called earnings management
against GAAP) but also in asking for appropriate
modifications when managers manipulate financial
data by, for example, overestimating earnings (the
so-called earnings management within GAAP; see
Brown, 1999; Rosner, 2003, p. 367).
In this way, auditors (BSA or external auditors)
can impose a correct application of GAAP,
contributing to improve the reliability of financial
statements, which depends (also) on the high
quality of the audit process, defined as the
probability that auditors discover errors and
anomalies in annual reports and reveal them to the
stakeholders (DeAngelo, 1981).
As a consequence, earnings management
behaviour represents an indirect way of measuring
the quality of auditing, the implicit assumption
being the following: the least aggressive are
earnings management behaviour, high are earnings
quality and the higher is the quality of auditing.
A wide research (Leuz et al, 2003), which analysed
earnings management in 31 countries, evidences
the relevance of the topic; Scholars calculated an
aggregate earnings management score, classifying
countries in a descending order (see Table 2).
Italy shows a high score, giving a wide diffusion of
earnings management behaviour.
In analysing audit quality, many studies assess that
the large and brand name audit networks (the Big
Eight, who have today become the Big Four)
guarantee a higher quality of auditing compared
with the non-Big four, because they are more
likely to curb opportunistic accounting practices
(see, among the others, Becker et al, 1998; DeFond
and Jiambalvo, 1993; Francis et al, 1999; Gaver
and Paterson, 2001; Teoh and Wong, 1993).
In this paper, it a different dichotomy is analyzed:
BSA vs. external auditors, in order to assess if the
choice of the Italian law (to assign financial audit
to the BSA) is correct (i.e. BSA guarantees the
same quality as external auditors) or not (i.e. BSA
assures a lower audit quality than external
auditors) (Cameran and Prencipe, 2011).
Table 2
Aggregate earnings management score
Countries
Aggregate earnings
management score
Austria 28.3
Greece 28.3
South Korea 26.8
Portugal 25.1
Italy 24.8
Taiwan 22.5
Switzerland 22.0
Singapore 21.6
Germany 21.5
Japan 20.5
Belgium 19.5
Hong Kong 19.5
India 19.1
Spain 18.6
Indonesia 18.3
Thailand 18.3
Pakistan 17.8
Netherlands 16.5
Denmark 16.0
Malaysia 14.8
France 13.5
Finland 12.0
Philippines 8.8
UK 7.0
Sweden 6.8
Norway 5.8
South Africa 5.6
Canada 5.3
Ireland 5.1
Australia 4.8
USA 2.0
(Source: Leuz et al, 2003)
Generally speaking, external auditors are outside
of the firm perimeters so they should have a
greater independence than members of the BSA; in
addition, while the BSA is in charge of both
administrative and financial audit, external auditors
focus their attention only on financial audit, having
more power in limiting earnings management
behaviour.
However, as stated above, auditing profession is
strictly regulated by Italian public authorities and
members of the BSA have the same level of
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In other words, financial statements of Italian firms
are taken as a basis for taxation.
Moreover, Burgstahler et al (2006) document that
stronger tax alignment is associated with more
earnings management and this effect is accentuated
for non-listed firms. This should imply a wide
approach to underestimate earnings.
On the other hand, the strong relationship between
Italian SMEs and banks should imply an opposite
approach to overestimate earnings: the better are
the performances showed by financial statements,
the higher is the probability to obtain credits from
banks.
However, as highlighted by Ball and Shivakumar
(2005), private companies are more likely to
resolve information asymmetry by an ‘‘insider
access’’ model, the main consequences being that:
• They are less likely to use public financial
statements in contracting with lenders;
• Their financial statements are correspondingly
more likely to be influenced by taxation.
Thereby, it is arguable that they need not have a
high quality auditing (related to high quality
financial statements). Therefore, on a sample of
386 Italian private firms, it is found that about 70%
of them are audited by the BSA.
Hypothesis 2 can be summarised as follows:
H2. Italian non-listed SMEs tend to
underestimate earnings.
4. Research Design and Research
Methodology
4.1. Research design
These hypotheses are tested by analysing financial
statements of three years (2008, 2009 and 2010) of
a sample of 386 non-listed companies which adopt
a traditional corporate governance model; are not
entities of public interest and are not obliged to
prepare consolidated financial statements (i.e. non-
listed companies type b in Table 1). All firms
included in the sample belong to the industrial
sector (classes C.10 to C.33 of the ATECO 2007
classification, which is similar to the US SIC one).
This sector is chosen because it is characterized by
a high incidence of fixed assets and, as a
consequence, of depreciation and amortisation
expenses.
AIDA Italian database is used, which includes
financial statements of all Italian limited liability
and stock corporation companies, assembled from
the Italian local Chamber of Commerce depository.
Firms that do not have any BSA are excluded,
according to the Italian civil code (art. 2435bis and
art. 2327). As a result, 12,560 firms compose the
whole population; considering ε = 0.05 and α =
0.05, From the whole population a simple random
sample of 386 firms is extracted, applying the
formula represented below:
n ≤
z(1−α/2)
2
4ε2
Table 3 describes the sample of firms whose
financial statements were analysed, also showing
the number of cases in which financial audit was
assigned to the BSA or to external auditors (single
auditor; non-BIG 4 company; BIG 4 company).
The table shows that about 70% of the Italian non-
listed firms included in the sample assign financial
auditing to the BSA.
This result is probably due to the above mentioned
characteristics of Italian non-listed firms, which
are prevalently family-owned and it appears
consistent with the findings of Niskanen et al
(2010), who highlighted that family firms are less
likely to use Big 4 auditors than nonfamily
business and that an increase in family ownership
decreases the likelihood of a Big 4 audit.
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TAt
=
α
+
β1(∆REVt – ∆RECt)
+
ß2 (PPEt)
+
ß3 (PROVt)
+ εt [3]
At–1 At-1 At-1 At-1 At-1
Where:
TAt = Total Accruals in year t;
∆REVt = Revenues in year t less revenues in year t–1;
∆RECt = Receivables in year t less receivables in year t–1;
PPEt = Property, plant and equipment + Long-term deferred expenses in year t;
PROVt = Provisions in year t, according to the Italian format of balance sheet;
At–1 = Total assets in year t–1;
εt = Error term in year t.
Total accruals include changes in working capital
components, such as receivables, inventory and
payables, which are influenced by changes in
revenues (∆REVt). The model also includes long-
term deferred expenses, according to the Italian
structure of balance sheet.
Property, plant and equipment and long-term
deferred expenses as well as changes in revenues
are included in the model with the aim of
controlling changes in non-discretionary accruals
caused by changing external conditions. Revenues
are also included in the model because they can be
interpreted as a rationale and objective measures of
the operation of a firm before managers’
manipulations, even if they are not completely
exogenous (they are used in order to control the
economic environment of the firm). Gross
property, plant and equipment as well as long-term
deferred expenses (PPEt) are included with the aim
of controlling the portion of total accruals related
to non-discretionary depreciation expenses; the
model includes gross value rather than changes in
these accounts because total depreciation expenses
(versus changes in depreciation expenses) are
included in the total accruals measure. The AIDA
database does not show gross value of these
accounts; as a consequence, net values are used,
which seem to be a significantly explicative terms
of the regression equation (Mariani et al, 2010:
33).
The model also includes Provisions for pensions
and similar obligations and Other Provisions,
according to the Italian structure of balance sheet
(items no. B1 and B3; see art. 2424 of the Italian
civil code), considering values rather than changes
in these accounts because total provisions for
contingent losses and liabilities (versus changes in
provisions) are included in the total accruals
measure (equation [1]).
In order to reduce heteroscedasticity, all variables
included in the model are scaled by lagged assets
(Piot and Janin, 2007, p. 436).
The general approach adopted in estimating
discretionary accruals via a regression model
consists in considering them as the unexplained
(i.e. the residual) components of total accruals
(Belkaoui, 2005, p. 456). In other words, error
terms ε (see equation [3]) represent estimated
discretionary accruals [E(DAt)]:
E(DAt) = TAt – α + β1(∆REVt – ∆RECt) + ß2 (PPEt) + ß3 (PROVt) [4]
At–1 At-1 At-1 At-1 At-1
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This approach derives from the assumption
that in a world without earnings management,
earnings and their variations tend to assume a
smooth distribution (Prencipe, 2006, p. 64); if
the empirical analysis shows a different (i.e.
non-smooth) distribution, that is to say
frequency distribution shows some
discontinuity especially near specified
threshold (i.e. near the zero), this denotes
earnings management behaviour and then less
reliability of earnings. In this paper, ROA is
used as a control variable in the regression
model (expected sign: ?):
• ATA; according to Francis et al (1999) a
positive coefficient for this variable is
expected because firms with high discretionary
accruals should have high absolute value of
total accruals (expected sign: +).
Earnings management and audit quality are
analysed by applying the regression model
separately for each year (2008, 2009 and 2010) in
order to maintain the statistical independence of
each variable and to take into account changes in
each variable from year to year, underlining the
possible effect of the economic and financial crisis
and highlighting the potential incidence of external
changing conditions.
5. Results
The descriptive statistics for the dependent and
explanatory variables are illustrated below.
Table 4
Variables Descriptive Statistics (n = 386)
Variables Mean St.dev. Q. 1 Median Q. 3 Min Max
(2008)
E(DAt) -0.164 0.168 -0.255 -0.154 -0.069 -0.987 0.928
|E(DAt)| 0.185 0.145 0.085 0.161 0.258 0.001 0.987
SIZE 16.913 1.027 16.249 16.677 17.355 15.049 21.282
LEV 0.651 0.194 0.522 0.682 0.810 0.103 0.980
AGE 28.085 15.428 19.000 27.000 36.000 1.000 100.000
ROA 0.019 0.065 -0.003 0.011 0.040 -0.513 0.295
ATA 13.807 1.536 12.850 13.711 14.682 9.312 18.824
(2009)
E(DAt) -0.023 0.093 -0.068 -0.024 0.020 -0.357 0.493
|E(DAt)| 0.069 0.067 0.023 0.050 0.092 0.000 0.493
SIZE 16.868 1.039 16.182 16.675 17.312 14.590 21.405
LEV 0.630 0.205 0.475 0.643 0.793 0.087 1.033
AGE 29.085 15.428 20.000 28.000 37.000 2.000 101.000
ROA 0.006 0.080 -0.015 0.005 0.033 -0.765 0.335
ATA 13.864 1.532 12.991 13.806 14.776 7.189 18.693
(2010)
E(DAt) -0.019 0.103 -0.071 -0.019 0.032 -0.487 0.604
|E(DAt)| 0.073 0.074 0.024 0.051 0.100 0.001 0.604
SIZE 16.926 1.034 16.240 16.727 17.411 14.984 21.529
LEV 0.642 0.203 0.499 0.665 0.804 0.064 1.030
AGE 30.085 15.428 21.000 29.000 38.000 3.000 102.000
ROA 0.019 0.055 -0.003 0.009 0.038 -0.196 0.253
ATA 13.847 1.572 12.939 13.842 14.750 7.191 18.873
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Table 6
Association between discretionary accruals and auditor type
Variables Estimate Std error t value p-value
2008
(Intercept) 0.330 0.131 2.522 0.012 **
TYPEt -0.030 0.016 -1.850 0.065 *
SIZEt -0.047 0.009 -5.169 0.000 ***
LEVt -0.092 0.037 -2.466 0.014 **
AGEt 0.000 0.000 0.640 0.523
ROAt -0.362 0.110 -3.302 0.001 ***
ATAt 0.053 0.006 9.147 0.000 ***
R2
0.225
R2
adjusted 0.212
2009 Estimate Std error t value p-value
(Intercept) 0.211 0.046 4.602 0.000 ***
TYPEt -0.002 0.006 -0.259 0.796
SIZEt -0.043 0.003 -13.508 0.000 ***
LEVt 0.009 0.013 0.730 0.466
AGEt 0.000 0.000 -0.523 0.601
ROAt 0.018 0.033 0.541 0.589
ATAt 0.042 0.002 19.666 0.000 ***
R2
0.518
R2
adjusted 0.510
2010 Estimate Std error t value p-value
(Intercept) 0.246 0.055 4.472 0.000 ***
TYPEt -0.006 0.007 -0.816 0.415
SIZEt -0.048 0.004 -12.446 0.000 ***
LEVt 0.044 0.016 2.818 0.005 ***
AGEt 0.000 0.000 1.759 0.079 *
ROAt 0.189 0.056 3.380 0.001 ***
ATAt 0.044 0.002 17.768 0.000 ***
R2
0.469
R2
adjusted 0.461
Significant at: 99% level (***); 95% level (**); 90% level (*)
R square and R square adjusted show a variable
trend, moving from 0.2 in 2008, to about 0.5 in the
subsequent years, explaining a sufficient part of the
total variability of the phenomenon investigated.
The variable TYPE is significant at 90% level only
in 2008, showing a negative sign; according to
Hypothesis 1, this result suggests that the internal
position of the BSA, compared to the external
position of an auditing company (or a single
auditor) affect positively the quality of auditing;
however, the variable is not significant in 2009 and
2010.
The variable SIZE is always significant at 99%
level, showing negative coefficients, as expected.
The variable LEV is significant in 2008 and 2010;
taking into account the high level of leverage ratio
illustrated in Table 4 (mean is over 0.6), this result
confirms the general situation of
undercapitalisation of many Italian non-listed
companies.
The variable AGE is not significant (except in
2010), so, as expected, it does not affect the quality
of auditing, confirming that it is not relevant in the
case of small and medium sized non-listed firms.
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literature (Niskanen et al, 2010; Trotman and
Trotman, 2010) only recently has analyzed the
relationship between auditing and family business,
pointing out that differences between family and
non family business could likely affect auditing of
these firms.
Secondly, the study could be improved by taking
into account the reasons for why many Italian non-
listed firms assign financial audit to the BSA. The
determinants of this choice could be highly related
with the earnings quality of Italian non-listed
firms, whereby could be a causality issue.
Acknowledgments
I would like to thank Alessandra Carraturo and
Vincenzo Nappo for their great support in the
previous version of the paper.
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